Tim Benzel, CFA, is a Senior Portfolio Manager for the SNW Investment Team. The SNW Investment Team manages approximately $3 billion in high-quality, tax-efficient and tailored fixed-income strategies for high-net-worth and institutional clients within a separately managed account construct.

California’s economy, and by extension its municipal bond market, can best be described as a series of booms and busts. When the U.S. economy and financial markets are strong, California’s financial situation typically does well relative to other states, as its top individual marginal state tax rate of 13.3% (the highest in the nation) drives revenue when residents are employed and capital gains are being generated. The opposite is also true. We need only look as far back as the post-financial crisis period of 2009 when California had to resort to issuing IOUs just to pay its bills.

California Muni-Bond Yield Premium Shifts Over Time

These boom-bust cycles impact not just California’s economy, but also its municipal-bond market. The yield relationship between California municipal bonds and bonds issued by municipalities in other states has varied over time as the state’s financial position has changed and tax policy at both the state and federal level has shifted.

Back in 2009, for example, at the height of the state’s budget crisis, the yield premium to buy California general obligation bonds versus national general obligation bonds was as wide as 1.67% in certain maturities. Today, that premium is roughly 0%.

Exhibit 1: Current Financial Strength Has Diminished the California Muni-Bond Yield Premium

Source: Thomson Reuters Municipal Market Data, as of 5/31/18

The strong state economy, a multi-notch ratings upgrade, the high state income tax rate, and the limits on state and local tax deductions included in the recent federal tax legislation have all contributed to California’s relative richness. For other California municipal credits, the relative yield picture is even more dramatic, with many bonds trading at yields well below other national municipals.

For California Residents, Adding National Muni Bonds May Offer Yield Advantages

What this means in practice is that California residents can buy national municipal bonds and realize a yield advantage versus California municipals, even after paying state taxes on bond interest payments from national municipal holdings. While there have always been opportunities to own non-California munis, they are becoming more frequent as California municipal bonds become more expensive. As such, we recommend that California investors diversify their holdings to include a large percentage of national municipals.

Recent bond issuances underscore the point. On May 21, 2018, the AA-rated University of California System issued $745 million in limited project revenue bonds of varying maturities. The 2023 maturity was priced to yield 1.81%, 0.27% lower than the AAA-rated national municipal yield curve. Compare this to the $186 million issuance by the Katy Independent School District in Texas on the same day. The Katy ISD bonds carry insurance from the Texas Permanent School Fund, are rated AAA, and offered a yield of 2.14% on the 2023 maturity, 0.06% higher than the AAA-rated national municipal yield curve. For California investors, the Katy issue carries both a higher rating and after-tax yield.

We use a tool called the Municipal Equivalent Yield Multiplier to calculate the amount of yield a California resident needs to earn on an out-of-state bond to equal the yield of an in-state bond. Currently this number is 1.153x. Worth noting, this calculation assumes the California resident is subject to the state’s aforementioned highest marginal effective state tax rate of 13.3%, which is applicable to investors with annual incomes above $1 million. For investors in a lower state tax bracket, the argument for investing out-of-state becomes even stronger.

Exhibit 2: A Comparison of Out-of-State Yield Requirements

Additional Diversification Benefits

In addition to the yield advantage, allocating a higher percentage of portfolios to non-California issues can improve the opportunity for sector, ratings category, and geographic diversification. Should the situation change and California municipal yields revert back to a more favorable relationship to national municipals, investors may want to shift the balance of their muni-bond portfolios accordingly. We believe that actively managing taxes is a key value-add for municipal managers and is something that should be continuously monitored as part of the investment process.